August 23 – India’s markets regulator, the Securities and Exchange Board of India (Sebi), is poised to introduce a comprehensive industry-wide stress test for small-cap funds. This marks a significant shift from the previous fund-specific assessments. Ananth Narayan, a whole-time member of Sebi, announced the upcoming change during his address at the Cafe Mutual Conference on Friday.
Narayan pointed out the impressive growth within the mid- and small-cap sectors, noting that over 40% of mid- and small-cap stocks have surged more than fivefold over the past five years. While Sebi has refrained from commenting directly on market valuations, Narayan emphasized the need for stakeholders to consider this rapid appreciation. He clarified that Sebi’s role is to ensure the stability of the financial system rather than to predict or influence market trends.
Filling the Gap
Historically, Sebi-mandated stress tests were conducted on an individual fund basis, with each small-cap fund independently disclosing the results of its assessment. While this approach provided insights into the resilience of specific funds, it did not offer a comprehensive view of the industry’s overall health. The forthcoming industry-wide stress test aims to address this gap by providing a more holistic perspective on the sector’s stability.
Narayan shared a mix of encouraging and cautionary findings from Sebi’s analysis. On a positive note, the stress levels within the industry have remained stable from March 2020 to March 2024, despite significant market fluctuations. This stability suggests that small-cap funds have generally managed to maintain their resilience.
However, Narayan also highlighted a critical concern: the rising average daily traded volumes within the small-cap segment, driven by sustained fund inflows. While this has supported market liquidity and helped small-cap funds manage their portfolios, there is uncertainty about the impact of a potential decrease in demand. If liquidity were to diminish and selling pressures increase, the risk of market stress could escalate.
Narayan emphasized the importance of suitability and appropriateness in the advisory process, particularly for mutual fund distributors (MFDs). Given the volatility of the small-cap segment, it is essential for MFDs to ensure that investments align with their clients’ risk profiles and investment objectives.
As Sebi moves forward with the industry-wide stress test for small-cap funds, market participants will be keenly watching the results. These findings will provide valuable insights into the sector’s resilience and offer guidance for investors and advisors navigating the complexities of small-cap investments.
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